Cap Rate Dynamics

The U.S. economy has been growing for more than eight years—the second-longest expansion since the 1850s—and average cap rates for U.S. commercial real estate have fallen throughout that period (Figure 1). The economy added another 250,000 jobs in October and cap rates have remained extremely firm, despite slowly rising interest rates.

Using CBRE’s most-recent semiannual cap rate survey, we explored whether the relationship between job growth and cap rates—so obvious at the national level—also held in local markets. If so, could this be used to create interesting late-cycle investment strategies?

Figure 1: Employment and real estate cycles are strongly correlated

Note: Employment data is seasonally-adjusted. Cap rate data is the quarterly average for all property types.
Source: CBRE Research, BLS, RCA, October 2018.

Figure 2 plots the cumulative number of jobs added since 2009 against the ratio of CBD office cap rates in H1 2018 vs. H1 2009 for 37 major markets. The relationship is not perfect and there certainly are other factors that determine cap rates at the local level. Nevertheless, there is quite a clear relationship between job growth and cap rates. The greater the number of jobs added, the lower the cap rate. How can we use this information?

Markets appearing above the trend line have seen less cap rate compression than the trend line would suggest based on the number of jobs added. It is in these markets that there might be unpriced opportunity. The closer a market is to the top right corner, the greater the job growth and the lower the cap rate compression. Given that job growth at a local level tends to compound and build momentum, the markets above the line—especially in the top right quadrant—are those most likely to see cap rate compression in the future.

Some possible opportunity markets include Dallas/Ft. Worth, Houston and Phoenix, which have all seen significant job gains with minimal accompanying cap rate compression. The opportunity is not only that these markets have considerable room for further compression as more jobs are added, but also that they offer a risk-mitigating spread as interest rates rise.